crowding out Crowding out at full employment

Transcription

1 C Crowding out refers to all the things which can go wrong when debtfinanced fiscal policy is used to affect output. While the initial focus was on the slope of the LM curve, now refers to a multiplicity of channels through which expansionary fiscal policy may in the end have little, no or even negative effects on output. Crowding out refers to all the things which can go wrong when debtfinanced fiscal policy is used to affect output. A first line of argument questions whether fiscal policy has any effect at all on spending. Changes in the pattern of taxation which keep the pattern of spending unaffected do not affect the intertemporal budget constraint of the private economy and thus may have little effect on private spending. This argument, known as the Ricardian equivalence of debt and taxation, holds only if taxes are lump sum (Barro, 1974). Some taxes which induce strong intertemporal substitution, such as an investment tax credit for firms, will have stronger effects if they are temporary; for most others, such as income taxes, changes in the intertemporal pattern may have only a small effect on the pattern of spending. The Ricardian equivalence argument is not settled empirically and its validity surely depends on the circumstances. A change in the intertemporal taxation of assets such as land or housing, leaving the present value of taxes the same, will have little effect on their market value, thus on private spending. An explicitly temporary income tax increase may have little effect on spending while the anticipation of prolonged deficits may lead taxpayers to ignore the eventual increase in tax liabilities. Evidence from specific episodes, such as the 1968 temporary tax surcharge in the United States, suggests partial offset at best. Changes in the pattern of government spending obviously have real effects. But here again, various forms of direct may be at work. Public spending may substitute perfectly or imperfectly for private spending, so that changes in public spending may be directly offset, fully or partially, by consumers or firms. Even if public spending is on public goods, the effect will depend on whether the change in spending is thought to be permanent or transitory. Permanent changes, financed by a permanent increase in taxes, will, as a first approximation, lead to a proportional decrease in private spending, with no effect on total spending. Temporary changes in spending, associated with a temporary increase in taxes, lead to a smaller reduction in private spending and thus to an increase in total spending. In summary, one should not expect any change in taxation or government spending to have a one-for-one effect on aggregate demand. An eclectic reading of the discussion above may be that only sustained decreases in income taxation, or the use of taxes that induce strong intertemporal substitution, or temporary increases in spending, can reliably be used to boost aggregate demand. The focus in what follows will be on these forms of fiscal expansion. Crowding out at full employment Not every increase in aggregate demand translates into an increase in output. This is clearly the case if the economy is already at full employment (I use full employment to mean employment when unemployment is equal to its

2 2 natural rate). While tracing the effects of fiscal expansion at full employment is of limited empirical interest, except perhaps as a description of war efforts, it is useful for what follows. If labour supply is inelastic, output is fixed and any increase in aggregate demand must be offset by an increase in interest rates, leaving output unchanged. In the case of an increase in public spending, private spending will decrease; in the case of a decrease in income taxation, private spending will in the end be the same, but its composition will change as the share of interest sensitive components decreases. (If labour supply can vary, the story is more complicated. See, for example, Baxter and King, 1993, for an analysis of changes in government spending in an otherwise standard RBC model.) This is just the beginning of the story, however. Over time, changes in capital and debt lead to further effects on output. The decrease in investment in response to higher interest rates leads to a decline in capital accumulation and output, reducing the supply of goods. If fiscal expansion is associated with sustained deficits, the increase in debt further increases private wealth and private spending at given interest rates, further increasing interest rates and accelerating the decline in capital accumulation (see, for example, Blanchard, 1985, for a characterization of these dynamic effects in an economy with finite horizon consumers). How strong is this negative effect of debt on capital accumulation likely to be? One of the crucial links in this mechanism is the effect of government debt on interest rates; empirical evidence, both across countries and from the last two centuries, shows surprisingly little relation between the two. This probably reflects, however, more the difficulty of identifying and controlling for other factors than the absence of an effect of debt and deficits on interest rates. Worse can happen. It may be that the fiscal programme becomes unsustainable. There is no reason to worry about a fiscal programme in which debt grows temporarily faster than the interest rate. But there is reason to worry when there is a positive probability that, even under the most optimistic assumptions, debt will have to grow for ever faster than the interest rate. When this is the case, it implies that the government can meet its interest payments on existing debt only by borrowing more and more. What happens then may depend on the circumstances. Bond holders may start anticipating repudiation of government debt and require a risk premium on the debt, further accelerating deficits and the growth of the debt. If they instead anticipate repudiation through inflation, they will require a higher nominal rate and compensation for inflation risk in the form of a premium on all nominal debt, private and public. What is sure is that there will be increased uncertainty in financial markets and that this will further contribute to decreases in output and in welfare. The historical record suggests that it takes very large deficits and debt levels before the market perceives them as potentially unsustainable. England was able in the 19th century to build debt-to-gdp ratios close to 200 per cent without apparent trouble. Some European countries are currently running high deficits while already having debt-to-gdp ratios in excess of 100 per cent, without any evidence of a risk premium on government debt. The threshold seems lower for Latin American economies. But even if one excludes this worst-case scenario, fiscal expansion can clearly have adverse effects on output at full employment. The relevant issue, however, is whether the same dangers are present when fiscal expansion is implemented to reduce unemployment, which is presumably when it is most likely to be used.

3 3 Crowding out at less than full employment The historical starting point of the discussion is the fixed price IS LM model. In that model, a fiscal expansion raises aggregate demand and output. The pressure on interest rates does not come from the full employment constraint as before but from the increased demand for money from increased output. Thus the fiscal multiplier is smaller the lower the elasticity of money demand to interest rates, or the larger the elasticity of private spending to interest rates. Fiscal expansion crowds out the interest-sensitive components of private spending, but the multiplier effect on output is positive. As output and interest rates increase, it is quite possible for both investment and consumption to increase. But what happens when the model is extended to take into account dynamics, expectations and so on? Can one overturn the initial result and get full or even negative multipliers? Even within the static IS LM, one can in fact get zero or negative multipliers. This is the case, for example, if money demand from agents is higher than that from the government and the change in policy redistributes income from the government to agents. While this case is rather exotic, a much stronger case can be made if the economy is small, open, and with capital mobility and flexible exchange rates, as in the Mundell Fleming model. In this case, with the interest rate given from outside, and fixed money supply, money demand determines output; fiscal policy leads only to exchange rate appreciation. Exchange rate-sensitive components are now crowded out by fiscal expansion. The multiplier is equal to zero. When dynamic effects are taken into account, other channels arise for. The analysis of these dynamic effects, with the dynamics of debt accumulation taken into account, was initially conducted under the maintained assumption of fixed prices and demand determination of output (Tobin and Buiter, 1976). Then, as debt was accumulating, private wealth and spending increased, leading to even larger effects of fiscal policy on output in the long run than in the short run. But the assumption of fixed prices, while debt and capital accumulation are allowed to proceed, is surely misleading; when prices are also allowed to adjust, the effects of fiscal policy become more complex, and more likely. This is because some of the full employment effects come back into prominence: if fiscal expansion is maintained even after the economy has reached full employment, then the perverse effects of higher interest rates on capital accumulation and full employment output come again into play. This is true even if deficits disappear before the economy returns to full employment; the economy inherits a larger level of debt, and thus must have higher interest rates and lower capital accumulation than it would otherwise have had. The fiscal expansion trades off a faster return to full employment for lower full-employment output. Anticipations of these full employment effects are likely to feed back and modify the effects of fiscal policy at the start, when the economy is still at less than full employment. Anticipations of higher interest rates, perhaps also of higher distortions due to the higher taxes needed to service the debt, may dominate the direct effects of higher government spending on demand, and lead to an initial decrease rather than an initial increase in demand and output. Symmetrically, fiscal consolidation, to the extent that it implies lower interest rates and lower distortions in the future, may be expansionary. This is even more likely to be the case if fiscal consolidation decreases the risk of default on government debt, and thus decreases the risk of major economic disruptions. There is indeed some evidence that, when initial fiscal conditions

4 4 are very bad, and the fiscal consolidation is large and credible, the net effect of consolidation may be expansionary (Giavazzi and Pagano, 1990). Crowding out: an assessment Should one conclude from this that fiscal policy is an unreliable macroeconomic tool, with small and sometimes negative effects on output? The answer is no. Fiscal Policy is likely to partly crowd out some components of private spending, even in the best circumstances, but there is little reason to doubt that it can help the economy return to full employment. Ricardian equivalence and direct warn us that not any tax cut or spending increase will increase aggregate demand. But there is little question that temporary spending or sustained income tax cuts will do so. Results of full at less than full employment, such as the Mundell Fleming result, are simply a reminder that the monetary-fiscal policy mix is important. In all cases, monetary accommodation of the increased demand for money removes the negative or the zero multipliers. That fiscal expansion affects capital accumulation, and output adversely at full employment, and that unsustainable fiscal programmes may lead to crises of confidence, is a reminder that fiscal expansion should not be synonymous with steady increases in the debt-to-gdp ratio even after the economy has returned to full employment. This shows one of the difficulties associated with fiscal expansion: if done through tax cuts, it has to be expected to last long enough to affect private spending, but not so long as to lead to expectations of runaway deficits in the long run. The room for manoeuvre is, however, substantial. Some taxes, such as the investment tax credit, work best when temporary. These can be used, as they work in the short run and have few adverse implications for the long run. Olivier J. Blanchard See also <xref=xyyyyyy> budget deficits; <xref=r000047> real business cycles; <xref=xyyyyyy> Ricardian equivalence theorem; <xref=t000069> Tobin, James. Bibliography Barro, R Are government bonds net wealth? Journal of Political Economy 82, Baxter, M. and King, R Fiscal Policy in general equilibrium. American Economic Review 83, Blanchard, O Debt, deficits, and finite horizons. Journal of Political Economy 93, Giavazzi, F. and Pagano, M Can severe fiscal contractions be expansionary? NBER Macroeconomics Annual 5, Tobin, J. and Buiter, W Long-run effects of fiscal and monetary policy on aggregate demand. In Monetarism, ed. J. Stein. Amsterdam: North-Holland.

88 Krugman/Obstfeld International conomics: Theory and Policy, Seventh dition nswers to Textbook Problems. decline in investment demand decreases the level of aggregate demand for any level of the exchange

Discussion #1: Chapter 4: The economy in the very long run: The Economics of Growth 1. Technological advances increase output in the short run but have no impact on long-run growth in output per capita,

Problem Set 4 Question 2 We are asked to label each of the seven statements as true, false or uncertain and to justify our answers briefly. (a) The aggregate supply relation implies that an increase in

4 Government spending and fiscal policy 4.1 GOVERNMENT SPENDING The scale of government spending Government spending is divided into the five categories shown in figure 4.1, where the different items are

Debt, consolidation and growth Robert Chote Annual meeting of OECD PBO and IFI officials Paris, 23 February 2012 Outline Very interesting paper. Will focus on UK approach to these issues rather than detailed

Chapter 26 An Aggregate Supply and Demand Perspective on Money and Economic Stability Learning Objectives Analyze the debate centering on the stability of the economy around its full employment level Define

CHAPTER 7: AGGREGATE DEMAND AND AGGREGATE SUPPLY Learning goals of this chapter: What forces bring persistent and rapid expansion of real GDP? What causes inflation? Why do we have business cycles? How

Fill in the Blanks. Module 1 S.Y.B.COM. (SEM-III) ECONOMICS 1. The continuous flow of money and goods and services between firms and households is called the Circular Flow. 2. Saving constitute a leakage

The Aggregate Demand Schedule Pedro Serôdio July 20, 2016 Learning objectives To understand: An essential part of the tool-kit. How the quantity theory of money, IS-LM and IS-MP models give rise to the

Chapter 7 AGGREGATE SUPPLY AND AGGREGATE DEMAND* Aggregate Supply Topic: Aggregate Supply/Aggregate Demand Model 1) The aggregate supply/aggregate demand model is used to help understand all of the following

Chapter 21 Monetary and Fiscal Policy in the ISLM Model 21.1 Factors That Cause the IS Curve to Shift 1) Other things equal, a decrease in autonomous consumption shifts the curve to the. A) IS; right B)

Commentary: What Do Budget Deficits Do? Allan H. Meltzer The title of Ball and Mankiw s paper asks: What Do Budget Deficits Do? One answer to that question is a restatement on the pure theory of debt-financed

Chapter 15 FISCAL POLICY* The Federal Budget Topic: The Federal Budget 1) Which of the following is considered a purpose of the federal budget? I. To help the economy achieve full employment. II. To finance

The Fiscal Policy and The Monetary Policy Ing. Mansoor Maitah Ph.D. Government in the Economy The Government and Fiscal Policy Fiscal Policy changes in taxes and spending that affect the level of GDP to

Agenda The IS-LM/AD-AS Model: A General Framework for Macroeconomic Analysis, art 3 rice Adjustment and the Attainment of General Equilibrium 13-1 13-2 General equilibrium in the AD-AS model Disequilibrium

Chapter 9 The IS-LM/AD-AS Model: A General Framework for Macroeconomic Analysis Economics 282 University of Alberta Introduction to The IS-LM Model This name originates from its basic equilibrium conditions:

ECON 3312 Macroeconomics Exam 3 Fall 2014 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) Everything else held constant, an increase in net

Sample Multiple-Choice Questions Circle the letter of each correct answer. 1. Which of the following best describes aggregate supply? (A) The amount buyers plan to spend on output (B) A schedule showing

ATHENS UNIVERSITY OF ECONOMICS AND BUSINESS DEPARTMENT OF ECONOMICS WORKING PAPER SERIES 09-2013 Government Debt, the Real Interest Rate and External Balance in an Endogenous Growth Model of a Small Open

Chapter 18 MODERN PRINCIPLES OF ECONOMICS Third Edition Fiscal Policy Outline Fiscal Policy: The Best Case The Limits to Fiscal Policy When Fiscal Policy Might Make Matters Worse So When Is Fiscal Policy

Spending, taxes, and the budget deficit Chapter 13 slide 0 Outline Government budgets Fluctuations in the deficit: purchases, transfers and taxes The effects of the government deficit slide 1 13.1 GOVERNMENT

IS-LM Intersection In the short run, the economy moves to the intersection of the IS and LM curves (figure 1). Production adjusts to demand to put the economy on the IS curve. Bond prices and the interest

KrugmanMacro_SM_Ch12.qxp 11/15/05 3:18 PM Page 141 Fiscal Policy 1. The accompanying diagram shows the current macroeconomic situation for the economy of Albernia. You have been hired as an economic consultant

Chapter 9 The IS-LM/AD-AS Model: A General Framework for Macroeconomic Analysis Multiple Choice Questions 1. The FE line shows the level of output at which the market is in equilibrium. (a) Goods (b) Asset

Topic I.4 concluded: Goods and Assets Markets in the Short Run a) Aggregate demand and equilibrium b) Money and asset markets equilibrium c) Short run equilibrium of Y and E d) Temporary monetary and fiscal

Chapter 10 1. The aggregate demand curve: A. is upward sloping because a higher price level is necessary to make production profitable as production costs rise. B. is downward sloping because production

WEB CHAPTER 2 Preview Monetary and Fiscal Policy in the ISLM Model S ince World War II, government policymakers have tried to promote high employment without causing inflation. If the economy experiences

Practiced Questions Chapter 20 1. The model of aggregate demand and aggregate supply a. is different from the model of supply and demand for a particular market, in that we cannot focus on the substitution

CHAPTER 11 Self Study Questions 1) The aggregate supply/aggregate demand model is used to help understand all of the following except A) inflation. B) business cycle fluctuations. C) the aggregate value

Problem Set for hapter 20(Multiple choices) 1. According to the theory of liquidity preference, a. if the interest rate is below the equilibrium level, then the quantity of money people want to hold is

1 Problem Set 5 Question 2 a) In what sense is money neutral? Why is monetary policy useful if money is neutral? In Problem Set 4, Question 2-Part (e), we already analysed the effect of an expansionary

QUIZ 3 14.02 Principles of Macroeconomics May 19, 2005 I. True/False (30 points) 1. A decrease in government spending and a real depreciation is the right policy mix to improve the trade balance without

Government Budget and Fiscal Policy 11 CHAPTER The National Budget The national budget is the annual statement of the government s expenditures and tax revenues. Fiscal policy is the use of the federal

A CLOSED ECONOMY IN THE LONG (MEDIUM) RUN For a closed economy, the national income identity is written as Y = C(Y T ) + I(r) + G the left hand side of the equation is the total supply of goods and services

University of Lethbridge Department of Economics ECON 1012 Introduction to Macroeconomics Instructor: Michael G. Lanyi CH 26 AD & AS Use the figure below to answer the following questions. Figure 26.1.1

The macroeconomics of oil Olivier Blanchard January 2007 Nr. 1 Nr. 2 Nr. 3 Four relevant dimensions On the supply side: Increase in cost for oil-using sectors. Main issue: Wage adjustment. On the demand

Econ 336 - Spring 2007 Homework 5 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) The real exchange rate, q, is defined as A) E times P B)

The session previously discussed important variables such as inflation, unemployment and GDP. We also alluded to factors that cause economic growth enabling us to produce more and more to achieve higher

2W EB CHAPTER Monetary and Fiscal Policy in the ISLM Model Preview Since World War II, government policymakers have tried to promote high employment without causing inflation. If the economy experiences

Economics 3422 Sample Final Examination Instructions: Put your name and PeopleSoft ID on the blue book provided. Put all your answers in the blue book provided. Turn both question sheet and blue book in

Chapter 12 Unemployment and Inflation Multiple Choice Questions 1. The origin of the idea of a trade-off between inflation and unemployment was a 1958 article by (a) A.W. Phillips. (b) Edmund Phelps. (c)

General ertificate of Education dvanced Subsidiary Examination January 2013 Economics EON2 Unit 2 The National Economy Monday 28 January 2013 1.30 pm to 2.45 pm For this paper you must have: an objective

Money and Public Finance By Mr. Letlet August 1 In this anxious market environment, people lose their rationality with some even spreading false information to create trading opportunities. The tales about

Economics 154a, Spring 2005 Intermediate Macroeconomics Problem Set 8: Answer Key April 11, 2005 1. Do numerical problem #4 on p. 425 in Chapter 11 of the textbook: An economy is described by the following

Econ 20B- Additional Problem Set I. MULTIPLE CHOICES. Choose the one alternative that best completes the statement to answer the question. 1.According to the theory of liquidity preference, the money supply

AUBG ECO 302 A F I N A L E X A M Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 35 questions, each 1.5 points 1) The Bigdrill company drills

Lecture 11-1 6.1 The open economy, the multiplier, and the IS curve Assume that the economy is either closed (no foreign trade) or open. Assume that the exchange rates are either fixed or flexible. Assume

Defining Surpluses and Debt Politics, Surpluses,, and Debt Chapter 11 A surplus is an excess of revenues over payments. A deficit is a shortfall of revenues relative to payments. 2 Introduction After having

NIESR Fiscal Consolidation During a Depression Nitika Bagaria*, Dawn Holland** and John van Reenen* *London School of Economics **National Institute of Economic and Social Research October 2012 Project

~~EC2065 ZA d0 This paper is not to be removed from the Examination Halls UNIVERSITY OF LONDON EC2065 ZA BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences,

Macroeconomics Revision Essay Plan (2): Inflation and Unemployment and Economic Policy (a) Explain why it is considered important to control inflation (20 marks) (b) Discuss how a government s commitment

TOPIC 5: The IS-LM Model in an Open Economy Annaïg Morin CBS - Department of Economics August 2013 The IS-LM Model in an Open Economy Road map: Two concepts to better understand openness The goods market

Fiscal Policy chapter: 28 13 ECONOMICS MACROECONOMICS 1. The accompanying diagram shows the current macroeconomic situation for the economy of Albernia. You have been hired as an economic consultant to

MACROECONOMICS Ayşe S. ÇAĞLI aysecagli@beykent.edu.tr 1 INFLATION and UNEMPLOYMENT PHILLIPS CURVE 2 Phillips curve Many people think there is a trade-off between inflation and unemployment. The idea originated

Eco 302 Name Final Exam 18 May 2011 Please write answers in ink. You may use a pencil to draw your graphs. Good luck. 120 points. 15 points each. Allocate your time efficiently. 1. In March 2009 the nominal